Saturday, April 14, 2012

Long Term Inflation Prospects and Oil Prices Threaten Economic Growth

Predictions are dangerous; especially those about the future. That said, planning is essential, and planning is all about predicting the future. So here goes.

Today we have low interest rates, low economic growth and low inflation.

We also have a government monetary policy designed to keep short term rates low for two more years.

On the other hand, currently we have both high oil prices and a relatively weak dollar.

Oil Prices Are Critical

If we want low inflation and a solid economic recovery, we'll need to get a grip on energy prices. Otherwise consumer spending will continue to struggle due to mountains of debt in addition to high oil prices. And lest we forget, millions of underwater home loans as well.

The quickest way to decrease gas prices would be to have a stronger dollar, since oil is priced in dollars worldwide. A complementary way would be to assure market participants that more oil is coming to the market. Another calming influence would be to achieve some degree of stability in the troublesome Middle East.


For consumers, high fuel and food prices are the most regressive taxes of all. For that reason and many others as well, we must do all we can to keep the lid on inflation.

Otherwise interest rates will rise to unsustainable levels, consumer spending will decline and our nation's debt and deficits will increase further. All very bad things to contemplate, because our current economic recovery would be brought to a screeching halt.

Why do we need to worry about inflation in today's soft economy? Well, consider what legendary economist Milton Friedman said about inflation's root cause, "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output."

Worried about inflation prospects yet? Well, at least please be concerned.

Since the Federal Reserve has expanded the money supply dramatically the past few years, inflation is a definite danger to our future economic prospects.

Thus, high oil prices can prove deflationary if the money supply doesn't expand to accompany higher fuel prices. On the other hand, they can be inflationary if the money supply expands to accommodate those unplanned higher fuel prices.

And expanding the money supply due to high oil prices is exactly what the policy makers mistakenly did in the 1970s after OPEC raised oil prices dramatically. This combination of high energy prices and high inflation ruined our domestic economy for many years. Let's hope we've learned that lesson. For what it's worth, I believe we have.

In simple terms, escalating oil prices are the biggest threat we have to maintaining a stable dollar, which in turn is a prerequisite to facilitating and encouraging solid and sustainable economic growth.

What Needs to Happen

The quickest and best way to stabilize or lower oil prices would be to increase the value of the dollar relative to other currencies. That's because oil is priced in dollars worldwide.

One good way to strengthen the dollar would be to increase interest rates, something not in the government's plan, at least with respect to short term rates. The economy needs to recover further before the government will allow short term interest rates to increase. Current expectations for a rate increase are 2014, although it could happen sooner.

The Real Inflation Worry

Here's the real kicker. Governments don't control longer term interest rates. So we need to watch these rates closely for clues as to how our economy will perform the next several years.

We want solid economic growth, so interest rates can gradually return to normalized levels. That will lead to a stronger dollar and lower oil prices, resulting in a stable economic environment and thereby facilitating sustainable long term economic growth.

That's the best way to get out of our current financial mess.

Thanks. Bob.

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